An Overview of Financial Management
Financial Statements, Cash Flow, and TaxesThe Annual ReportThe firms annual report is the most important report that corporations issue to shareholders.Contains two types of informationVerbal statement discussing recent operating results and future operationsSet of financial statements that report on the firms financial position, earnings, cash flow, and stockholders equity over the past few years.2Financial StatementsBalance sheetIncome statementStatement of cash flowsStatement of stockholders equity3Balance SheetShows what assets the company owns and who has claims on those assets as of a given date.
Assets are found on the left-hand side and are typically shown in order of their liquidity.
Assets are divided into two major categories:Current assetsLong-term assets4Know balance sheet and income statement
Balance sheet---AssetsCash and equivalents InvestmentsAccts receivableCurrent assetsPlant, Property, etc. (Fixed)Long Term assetsIntangibles -----Total assets
Liabilities and equity- Acct Payable- Wages and Taxes (Accruals)- Notes Payable ------Current LiabilitiesLong term debt (Dividends that we dont pay back right away)Common stockPreferred stock (Forever dividends)Retained earning------Total Liabilities and equity4Balance Sheet (cont.)Current assets include cash and equivalents, accounts receivable, and inventory. Often called Working Capital because these assets turn over.Net Working Capital is the difference between current assets and current liabilities.Net Operating Working Capital distinguishes between free liabilities and interest bearing notes payable.Long-term assets are assets with an useful life exceeding one year. They include physical assets such as plant and equipment and intellectual property.5Net Operating Working CapitalCA-[CL-NP]5Balance Sheet (cont.)Claims against assets are on the right-hand side and include liabilities and stockholders equity.Liabilities are further divided into current liabilities and long-term liabilities.Current liabilities are obligations that need to be paid off within a year.Accounts payableAccrualsNotes PayableLong-term debt includes bonds that mature in more than one year.
6Balance Sheet (cont.)Common stockholders equity is capital supplied by common stockholders and represents ownership.This portion is divided into two accountsCommon stockRetained earningsSome companies may also have preferred stock which is a hybrid between common stock and debt.78
Income StatementSummarizes the firms revenues and expenses during a reporting periodIn order to compare companies operating performances, its essential to focus on their earnings before deducting taxes and interest Referred to as EBIT or operating incomeDerived from the firms regular core business9Income Statement-----Sales-operating costs-----EBITDA-depreciation and ammonization ----EBIT-interest-----EBT-taxes-----Net Income9Income Statement (cont.)Depreciation is an annual noncash charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were used up in the production process.
Amortization is similar to depreciation except it applies to intangible assets.
EBITDA represents earnings before interest, taxes, depreciation, and amortization
1010Income Statement (cont.)11
Tied together through the retained earnings11Balance Sheet and Income StatementThese two financial statements are tied together through the retained earnings account on the balance sheet.Net income dividends paid = retained earningsRetained earnings from a given year are added to the cumulative retained earnings from prior yearsRetained earnings are also reported in the statement of stockholders equity12Statement of Cash FlowsThe most important of the 4 statements well examine todayRemember that managements goal is to maximize stockholders wealthSince stock is an asset, we know the value of any asset is the present value of all expected future cash flows discounted at our discount rateTherefore, the Statement of Cash Flows provides us with insights on the firms operating, investing, and financing activities over a given period.13Statement of Cash Flows (cont.)The companys cash position relates the Balance Sheet and Statement of Cash Flows togetherThe cash position is determined by 3 types of activitiesOperating activities includes net income, depreciation, and changes in working capital other than cash and short-term debtInvesting activities includes purchases or sales of fixed assetsFinancing activities includes raising cash by issuing short-term debt, long-term debt, stock, using cash to pay dividends, buying back stock, or retiring bonds.Summary shows the net decrease or increase in cash at the end of the year based on the 3 activities.1415
Statement of Stockholders Equity16Retained earnings represents a claim against assets
Retained earnings as reported on the balance sheet do not represent cash and are not available for the payment of dividends or anything else
Retained earnings represent funds that have already been reinvested in the firms operating assetsYou can pay out dividends larger than what you received example WWE
D/rs-g
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Some Additional NotesFinancial statements provide a great deal of useful information.However, investors need to be cautious when they review financial statements.Companies are required to follow GAAP, however managers still have a lot of discretion in deciding how and when to report certain transactions
Bottom line cash flow, not accounting income matters the most18How Financial Statements are UsedTraditional they are used by creditors and tax collectorsnot managers and stock analysts.
Consequently, corporate decision makers and security analysts often modify accounting data to meet their needs.
19Free Cash FlowFree cash flow (FCF) is one of those metrics.
Management is not completely free to use the available cash flow however it pleases.
FCF is the amount of cash that could be withdrawn without harming a firms ability to operate and produce future cash flows.
FCF = [EBIT(1-T) + (D&A)] [Capt. Ex. + NOWC]
NOWC = Current Assets [Current Liabilities Notes Payable]
20Money that can be taken without harming the firm.
20Free Cash Flow (cont.)A positive FCF indicates the firm is generating more than enough cash to finance its current investments in fixed assets and working capital.
A negative FCF means the company lacks sufficient internal funds to finance its investments in fixed assets and working capital. Hence, it will have to raise outside capital to continue these investments.
Negative FCF is not always bad.
FCF is considered by many as the single most important number that can be developed from accounting statements.21Negative it could be a growth company
21MVA and EVAAccounting statements do not reflect market values
Therefore, not a good metric for evaluating manager performance
As a result, financial analysts have developed two additional performance measuresMarket Value Added (MVA)Economic Value Added (EVA)
22MVAShareholders wealth is maximized by maximizing the difference between the market value of a firms common equity and the book value as shown on the Balance Sheet.
MVA = Market Value of Equity Book Value of Equity
Represents the difference between the money a firms stockholders have invested since its founding versus the cash they could receive if they sold the firm.
Applied to the whole firm.23Small cap 10b or lessMed cap 10b-20bLarge cap x > 20b
23EVAEVA is closely related to MVA
EVA = NOPAT After-tax dollar cost of capital
EVA = EBIT(1-T) (Total investor-supplied operating capital)(After-tax percentage cost of capital)
Total investor-supplied operating capital equals the sum of net fixed assets and net operating working capital24EVA (cont.)EVA is an estimate of a business true economic profit for a given year.
EVA differs from accounting profit by deducting the cost of equity.
Positive EVA on an annual basis will help ensure that MVA is also positive.
Can be used for divisions along with the whole firm.25Individual TaxesU.S. tax system is progressive
Marginal tax rate is the rate applicable to the last unit of a persons incomeRates begin at 10% and rise to 39.6%
Average tax rate is calculated as taxes paid divided by taxable income
Interest earned is taxable incomeState and local debt are usually exempt from federal taxes and are nicknamed munis
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Capital Gains & DividendsA capital gain is the profit from the sale of a capital asset (not normally bought and sold in the course of business) for more than it purchase price.
Short-term (less than a year) capital gains is added to ordinary income and taxed at that rate.Long-term (greater than year) capital gains is taxed at a lower rate - 0% for the 10%~15% brackets; 15% for the 25%~35% brackets; and 20% for the 39.6% bracket
Dividends are taxed in an identical manner as long-term capital gains2828Corporate TaxesCorporate tax rates are also progressiveRates begin at 15% and increase to 35%
Interest and capital gains are taxed at ordinary income levels
Dividends get special treatment70% of dividends received are excluded from taxable income, while the remainder is taxed at the ordinary tax rate (only if corporation owns less than 20% of the dividend paying corporation)29Different income brackets pay different rates (progressive)
Munies tax free bonds
29Corporate Taxes (cont.)There is a double tax on dividend incomeThe corporation that paid the dividend is first taxed, and then the individual who receives it is taxed again
Our tax system encourages debt financing over equity financing because interest paid is tax deductible while dividends paid are not
Tax Code allows firms to carry losses back (prior 2 years) to offset profits and carry losses forwards (next 20 years) to offset future profits 30Because you get the debt financing 30Corporate Taxes (cont.)If a corporation owns 80% of more of another corporations stock, it can aggregate income and file on consolidated tax return
An S corporation enjoys the advantages of the corporate form of organization yet still receives the tax advantages of a proprietorship or partnership
Depreciation plays an important role in income tax calculations Larger depreciation -> Lower taxable income -> Lower tax bill -> Higher operating cash flow 31
